Down payment insurance: a nice idea in Wonderland

People will begin buying homes again if the federal government protects their down payment from risk of loss, according to University of California economist, James A. Wilcox.

Wilcox claims that there is a vast nationwide demand for so-called “buyer’s side mortgage insurance” among potential homebuyers who refuse to pull the trigger out of fear that prices will drop further and thus vaporize their cash invested as a down payment. In other words, there exists a great “shadow demand” for homeownership of able buyers who are simply not willing.

The pitch: Homebuyers would purchase down payment insurance from the federal government for a one-time fee (comparable to FHA mortgage insurance premium (MIP) paid at closing in the amount of, say, one percent of the purchase price. After three years, if the home declines in value, the government would then either cut a check to the homeowner or apply a credit to the mortgage principal in the amount of the home’s lost equity, limited to the down payment amount. If there is no decline in value after the three-year window, no payout would occur and the government would retain the insurance premium as revenue.

The conclusion: With such a safety net in place, gun-shy buyers would have greater confidence to invest their savings in the purchase of a home. Home sales volume would thus be stimulated, prices would increase and jobs would be generated in the housing sector once again, leading to a virtuous market cycle.

first tuesday take: This game privatizes profit if the price of housing goes up, and socializes losses if prices drop further. Sound familiar? The housing market just experienced this in 2008 with the lender bailouts.

Since lenders benefit from federally-backedmortgage insurance, why not offer buyers the same loss protection so the occurrence of a bear market won’t likewise vanquish their investment?

The reason why such a federal insurance program does not yet exist is because of the long-standing illusion propagated by lenders, government and housing industry ideologues that real estate in the U.S. always appreciates in value — the money illusion that millions of homeowners got wise to during the Great Recession. This illusion is, after all, one-sided. If the government and lenders believed that home values in the U.S. were forever on a perpetual upswing, why were mortgage insurance and guarantees invented for nearly all home loans in the first place?

But that is really neither here nor there. The problem with the thoughtful economist’s proposal is his notion that the only thing pinning-up this purported shadow demand is consumer confidence. The real reason why the so-called able buyers are not buying has to do with the global credit crunch and the zero bound interest rate barrier that Paul Krugman refers to as the liquidity trap.

Lenders are sitting on nearly two trillion dollars in cash reserves that they refuse to lend — mega-cash that they have been able to stockpile almost solely due to the taxpayer-funded bailouts of 2008, both from the Treasury and the Federal Reserve.

Everyone, including the Fed, is wondering how to get this cash circulating again with inflation below normal range, especially given the fact that the cost of borrowing for lenders right now is essentially free. So while there may in fact be a vast swath of ready and able buyers waiting on the sidelines of homeownership, they are met with closed doors from the very institutions that were put in place (and saved by the federal government) to lend money and facilitate spending (read: buy homes).

This reluctance to lend is only further compounded by a broken FICO credit-rating system that determines creditworthiness based on the same mysterious algorithms that were used to give junk mortgage-backed bonds (MBBs) AAA status during the housing bubble. [For more information on the broken credit rating system, see the December 2011 first tuesday article, The FICO farce.]

Offering down payment protection to potential buyers may nudge some risk averse but otherwise able buyers into the realm of homeownership. But this does nothing to stimulate lending on behalf of the most risk-averse rentier class in history, the Wall Street Bankers. We no longer have the local branch with its loan officers that made decisions at their desk; they are now commissioned secretaries who take applications with nary a loan officer in sight. [For more information on the rentier class, see the September 2011 first tuesday article, Rentiers and debtors: why can’t they get along?]

The only action that will ameliorate risk in today’s markets is the resurrection of the most fundamental economic indicator in the land: gross domestic product (GDP). This, of course, will only occur once jobs are created and increased exchange takes place, both in home sales and exports.

Perhaps our economists ought to think of how to create jobs first. This issue of how to sell homes may just disappear. [For an analysis of the economic driver debate, see the January 2012 first tuesday article, Why real estate won’t save us this time.]